Michael Santoli

An Investor Cheat Sheet on J.P. Morgan ‘Whale’ Flap

The Senate committee report blasting J.P. Morgan Chase & Co. (JPM) executives for allegedly misleading regulators and investors about the extent and details of its $6 billion derivatives-trading lost last year is unflattering, and the hearings will no doubt pose embarrassing questions to the bank executives involved.

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But for an investor, either in J.P. Morgan, other banks or the broad stock market, neither the provocative details of emails and outbursts in the report nor the whirl of the Senate hearings are particularly relevant looking ahead. Here are some key elements of this episode that investors ought to keep in mind:

- The report, overseen by bank critic Sen. Carl Levin (D-Mich.), almost by definition contains the most damning revelations we are likely ever to learn about the episode. Levin had comprehensive access to employee communications and interviews. He and his staff had motivation to describe and point out the events that appear closest to internal mismanagement or cover-up. This minimizes the ongoing “headline risk,” as it seems all the details speak to a terrible trade, badly handled, with lots of haggling over how to underplay its damage -- which is roughly what it seemed like before.

- J.P. Morgan shares, down about 2% today from a 52-week high reached yesterday, are absorbing the news of the evasive behavior reasonably well, nothing close to the 30% drop last spring when the losses were first coming to light. Indeed, the Federal Reserve’s skeptical conclusion on J.P. Morgan’s capital plan in its “stress test” results could have as much to do with that loss as the Senate report. The Fed’s reaction could crimp the bank’s aggressive plans to repurchase stock over time.

- Indeed, the way the broad market handles this news is of some relevance. Stocks have been rising in almost a straight line all year, the Dow working on a 10-day streak of gains. Various measures imply stocks are positioned for some sort of pullback to reset investor attitudes and refresh buying power, as happened last year.

The fact that the broad market has not seized on the J.P. Morgan news and stress-test scrutiny as an excuse to dip significantly suggests the tape’s imperturbability (the broad market is down just slightly early Friday following 10 straight days of gains for the Dow) is intact for the moment. Indeed, it’s striking that McGraw-Hill Cos. (MHP) shares have recovered nearly half of the losses caused by the Justice Department’s suing its Standard & Poor’s division over allegedly fraudulent credit ratings in the housing bubble days. Next week, after the volatility-compressing expiration of options and futures this Friday, we may get a cleaner read on the market’s resilience.

- The most important thing that might arise from the Morgan flap is a potentially more stringent set of regulations on banks’ use of derivatives in their trading businesses. The “London Whale” book of trades has always been characterized by J.P. Morgan as an intended hedge against the bank's natural commercial-credit exposures. But if so, it was an implicit, indirect hedge, and the idea of what is properly seen as a risk-management trade and what is a speculative proprietary position resides in a gray area. A strict interpretation of derivatives usage rules in the Dodd-Frank financial regulations could crimp bank profitability further in coming years.

- Finally, it’s worth noting that the appearance of Morgan executives in uncomfortable interrogations on Capitol Hill and the Fed’s calling-out of J.P. Morgan and Goldman Sachs Group Inc. (GS) for unsatisfactory capital-deployment plans in a future crisis should offer some comfort. True, this all shows how dauntingly complex and hard-to-manage our large financial institutions are. But hearing about the risks via official channels is at least a slightly reassuring sign that banks are already being kept on a shorter leash than they were just a few years ago. Always assume there are latent time bombs inside large banks; better to get at least occasional signals that someone hears the ticking.

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